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Edited Transcript of LITE earnings conference call or presentation 6-Feb-18 1:30pm GMT

Q2 2018 Lumentum Holdings Inc Earnings Call

Milpitas Oct 4, 2018 (Thomson StreetEvents) -- Edited Transcript of Lumentum Holdings Inc earnings conference call or presentation Tuesday, February 6, 2018 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Aaron L. Tachibana

Lumentum Holdings Inc. - Former CFO & Executive VP

* Alan S. Lowe

Lumentum Holdings Inc. - President, CEO & Director

* Christopher W. Coldren

Lumentum Holdings Inc. - Senior VP of Strategy & Corporate Development and Interim CFO

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* Douglas G. Clark

Goldman Sachs Group Inc., Research Division - Equity Analyst

* George Charles Notter

Jefferies LLC, Research Division - MD & Equity Research Analyst

* James Martin Kisner

Loop Capital Markets LLC, Research Division - SVP

* Joseph Eric Wolf

Barclays Bank PLC, Research Division - MD & Head of Equity Research

* Mark Daniel Kelleher

D.A. Davidson & Co., Research Division - VP & Senior Research Analyst

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Patrick Michael Newton

Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Senior Analyst

* Richard Cutts Shannon

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Thejeswi Banavathi Venkatesh

UBS Investment Bank, Research Division - Associate Director and Analyst

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

* Troy Donavon Jensen

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning. My name is Kelly, and I will be your conference operator today. At this time, I would like to welcome everyone to Lumentum Holdings Fiscal Second Quarter 2018 Financial Results Conference Call. (Operator Instructions)

Chris Coldren, Vice President, Strategy and Corporate Development, you may begin your conference.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP of Strategy & Corporate Development and Interim CFO [2]

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Thank you, Kelly. Welcome to Lumentum's Second Quarter Fiscal 2018 Earnings Call. This is Chris Coldren, Vice President of Strategy and Corporate Development. Joining me on today's call are Alan Lowe, President and Chief Executive Officer; and Aaron Tachibana, Chief Financial Officer.

This call will include forward-looking statements, including statements regarding the markets in which we operate, potential market sizes, trends and expectations for products and technology, purchasing trends and demand for our products, momentums expected, financial performance, expenses and position in the market. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. We encourage you to review the most recent filings with the SEC, the risk factors described in our 10-Q filing for our second quarter ended December 30, 2017, that we expect will be on file with the SEC later today. The forward-looking statements we provide during this call, including projections for future performance, are based on our reasonable beliefs and expectations as of today. Lumentum undertakes no obligation to update these statements except as required by applicable law.

Please also note, unless otherwise stated, all results and projections are non-GAAP. Non-GAAP financials should not be considered as a substitute for or superior to financials prepared in accordance with GAAP. Our press release with our second quarter fiscal 2018 results is available on our website, www.lumentum.com, under the Investors section, and includes additional details about our non-GAAP financial measures and a reconciliation between our GAAP and non-GAAP results. Our website also has our latest SEC filings, which we encourage you to review, and supplementary slides relating to today's earnings release. Finally, a recording of today's call will be available by 11:30 a.m. Pacific Time this morning on our website.

Now I would like to turn the call over to Alan for his comments and second quarter business highlights.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [3]

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Thank you, Chris. Good morning, everyone. 3 years ago, Lumentum announced -- Lumentum's name was announced to the public. The name Lumentum not only refers to the emission of light, it conveys momentum and forward progress. I think it is fitting to reflect upon this now as we discuss our second quarter results where we achieved record -- new record revenues and earnings. These results exemplify the strong forward momentum we have in achieving our strategic priorities.

Headlining our results was the very strong performance of our 3D sensing business. We supply laser diodes into leading consumer electronic manufacturers, who are in the early stages of introducing 3D sensing capabilities into their products. There is clear momentum in this market and in our business serving it.

Before providing more details on 3D sensing, I'd like to highlight that we had new record revenues from nearly all of our laser product lines. Our commercial lasers segment achieved new record revenues, driven by strong demand from customers' supply and equipment used in the production of next-generation consumer electronic devices. Devices such as new smartphones and wearables are increasingly using components that require laser-based processes. These include flex circuitry, LCD and OLED displays and advanced semiconductor chips. Our industrial laser -- our industrial diode laser production -- product line also achieved record revenues, driven by strong demand from customers building material processing tools, including those building kilowatt-class fiber lasers with our pumps.

In addition, our Telecom pump laser product line achieved new record revenues in the second quarter as network operators around the world continue to light up new fiber and expand their networks. These second quarter results highlight our strategy of leveraging our photonics technologies across multiple growing markets critically dependent on photonics, investing in and quickly ramping the best products and focusing on close relationships with market-leading customers is succeeding. This is a very exciting time with Lumentum.

Now for more details. In the second quarter, we rapidly expanded 3D sensing pixel capacity and production volumes. Due to strong execution, we shipped more than $200 million of 3D sensing VCSEL arrays. This revenue substantially exceeded the amount considered in our second quarter guidance. The steep production ramp and our consistently high yields were enabled by our proprietary laser design and production capabilities that have taken us years to develop. We have irreplaceable learnings and volumes of field data from multiple high-volume 3D sensing ramps. This, along with our decades of experience supplying laser diodes into the industrial and subsea communication markets, allows us to produce high performance, highly reliable volumes of lasers.

Our laser chip and manufacturing processes are specifically designed to enable the short-design cycles and high-volume production ramps needed by the fast pace of consumer electronics customers. These requirements are quite different from those of other customers in the industrial and communications markets. We spent nearly a decade developing unique capabilities to address the 3D sensing market. During the second quarter, we continued to book new 3D sensing orders and exited the quarter with a solid order backlog for deliveries through June.

Looking to the third quarter. In our guidance, we are projecting 3D sensing revenues to be down significantly. Third quarter projected 3D sensing revenues consist primarily of revenue from shipments already made to date with the conservative view on revenues from additional shipments this quarter. Demand from consumer electronics customers can be seasonal as we saw in prior 3D sensing cycles. Given our 3D sensing customer mix, we are in a seasonally weaker period now. We expect third quarter revenues to include contributions from new 3D sensing customers in the Android space, including some who have designed in our newest high-performance edge-emitting lasers. These new opportunities are in the early stages and are only expected to contribute a few million dollars to third quarter revenues. These new customers are expected to drive far more business as we look to our fiscal 2019 and beyond. We believe 3D sensing market is accelerating. Underscoring this is recent public commentary from industry leaders and my experience at the Consumer Electronic Show in Las Vegas a few weeks ago. We met with leaders from major smartphone manufacturers as well as other consumer electronics and automobile system leaders. We heard detailed plans to incorporate 3D sensing into numerous brands, models and applications throughout calendar 2018 and 2019. Consumer electronic manufacturers throughout China, Korea and North America are looking to 3D sensing to enhance security, to enable augmented and virtual reality and to add other new functionality. Given the volume that these manufacturers produce, it is not difficult to imagine the annual market for 3D sensing lasers to exceed $1 billion in the next year or 2. To capitalize on these market opportunities, we are rapidly ramping our R&D investment in 3D sensing and in additional manufacturing capacity for VCSELs and edge-emitting lasers. In fact, given lengthy qualification times, we are already in the process of qualifying new equipment to permit even higher production starts in our fourth quarter for first half fiscal 2019 deliveries. With our proven manufacturing scalability, proven field reliability and new product pipeline, we are positioned well to be the partner of choice for 3D sensing customers around the world.

Turning to our optical communication business. Second quarter demand for optical communication products was highly varied between our different product lines. As highlighted earlier, Telecom pump laser sales achieved new record revenues. Gross revenues rebounded quarter-on-quarter. North American customers had strong demand, having worked down their ROADM inventories in prior quarters. We expect strong North American ROADM demand to continue in the quarters ahead. Chinese demand for ROADMs was strong in the second quarter, and we expect will grow throughout calendar year 2018 and 2019 as China continues its march towards large-scale domestic deployments. In contrast to pumps and ROADMs, coherent components and Datacom transceivers declined sequentially. We believe the long-term trends are favorable in our Optical Communications business. The growth in bandwidth across the world's data centers and communications networks is unrelenting. Network and cloud operators' only solution to deal with the enormous growth in data they are experiencing and on which their business models depend is to deploy more advanced, higher-performance optical networks.

And finally, turning to our commercial lasers business. Revenue increased significantly quarter-on-quarter to new record levels given -- driven by growth in both micromachining and kilowatt fiber lasers. Demand continues to be strong for both of these product lines, and we expect commercial lasers to be on a growth trajectory over the coming quarters.

I've highlighted significant long-term trends that make the markets in which we participate increasingly dependent upon our photonics solutions. These trends, along with our investment in new products and technology and intimate relationships with industry-leading customers, create strong long-term growth opportunities for us. It is indeed an exciting time at Lumentum.

I will now hand the call over to Aaron for more details on our financial results and our guidance for the third quarter of fiscal 2018.

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [4]

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Thank you, Alan. Net revenue for the second fiscal quarter was $404.6 million, which increased 66.4% sequentially and 52.7% compared with the same period last year. The sequential growth was driven by the ramp of our 3D sensing products, Telecom pumps and ROADMs and strong demand for micromachining and kilowatt laser products. GAAP gross margin for the second quarter was 42.3%. GAAP operating margin was 22.4% and GAAP diluted net income per share was $3.17. The net income per share includes a onetime $124 million income tax benefit from the valuation allowance release, which was previously set up against our deferred tax assets several years ago. The release of reserves occurred at this time due to cumulative profits generated over the last 2.5 years as a standalone company.

Our second quarter non-GAAP gross margin was 44.9%, which increased 10.9 percentage points sequentially and 8 percentage points compared with the same period last year. Non-GAAP operating margin was $114.6 million, and operating margin for the second quarter was 28.3% and increased 16.5 percentage points sequentially. The increase in operating margin was primarily due to the 10.9 percentage point increase in gross margin from favorable mix and improved operating leverage from higher volume. Our second quarter operating margin performance demonstrates the strength of our operating model as volume increases. We delivered $86 million or 300% more operating income dollars sequentially on incremental revenue of $161 million. Non-GAAP net income was a record high of $107.8 million for the second quarter. Non-GAAP earnings per share was $1.67 based on a fully diluted share count of 64.6 million and included $900,000 of interest income and a $7.7 million tax expense.

Now for some additional detail. Optical Communications revenue was $360.1 million, an increase of 73% sequentially and 52% compared with the same period last year. During the quarter, we significantly ramped consumer and industrial revenue, which includes 3D sensing, while Telecom was flat and Datacom declined as previously expected. Telecom revenue at $110.2 million was flat sequentially and declined 31% compared with the same period last year. Although Telecom did not grow, our industry-leading ROADMs increased 22% quarter-on-quarter. Datacom was $34.4 million and declined 24% sequentially and 49% compared with the same period last year. Consumer and industrial revenue at $215.5 million increased 312% sequentially and over 2,000% compared with the same period last year. The significant growth for consumer and industrial revenue came from our 3D sensing products.

Optical Communications gross margin at 45% increased 10.3 percentage points sequentially from the favorable mix of products and higher volumes. Commercial lasers revenue was $44.5 million, an increase of 26% sequentially and an increase of 57% compared with the same period last year. The increase in volume was from both micromachining and kilowatt laser products. Second quarter commercial lasers gross margin was 44.7% and increased 14.7 percentage points sequentially. The commercial lasers gross margin returned to the mid-40% level, which reflects the longer-term profile we expect.

Operating expenses totaled $67.2 million or 16.6% of revenue compared with $54.1 million or 22.2% of revenue for last quarter. R&D expense was $38.9 million and SG&A expense was $28.3 million. The increase in operating expenses was primarily due to our investments in new product programs, infrastructure investments to support growth and variable incentive compensations. We exited the second quarter with cash and short-term investments of $624.5 million, which increased $92 million sequentially. Capital equipment additions were approximately $26 million in Q2.

Now on to our guidance for the third quarter of fiscal 2018, noting again that all projections are on a non-GAAP basis. We project net revenue for the third quarter to be in the range of $280 million to $305 million with operating margin in the range of 15.5% to 18% and earnings per share to be in the range of $0.65 to $0.80. For Q3, we expect our non-3D sensing revenue to increase by $25 million to $35 million sequentially.

Now I will turn the call back over to Chris to begin the Q&A session.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP of Strategy & Corporate Development and Interim CFO [5]

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Thank you, Aaron.

I would like to ask everyone to limit discussion to 1 question and 1 follow-up. Kelly, let's begin the question-and-answer session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Alex Henderson from Needham & Company.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [2]

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I guess the problem, from our perspective, at this point, is how do we think through the ramp of that business and the seasonality of that business? Obviously, down a lot into the March quarter, but it looks like -- should we be thinking the June quarter is the seasonal trough? And then, could we actually have growth off of the fourth quarter as you expand the multiple lines, multiple vendors as we get into the calendar fourth quarter of the year? How do we think about the curve over the course of the year? Obviously, if it's a billion-dollar market in a year or 2. You guys have the lion's share of that, but what's the shape of that curve to deliver it?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [3]

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Yes. Alex, good question. Thanks. I think -- we don't guide more than 1 quarter at a time, but I'd tell you, as I said in my introductory comments, we're investing today both in edge-emitters as well as additional capacity for VCSELs in anticipation of the second half of the year -- calendar year that has been extremely strong. Whether some of that gets pulled into the June quarter or not, it's hard to say. I think it really depends upon both our Android customers' ramps and when they actually take place. And as I said, we have a few million dollars in the March quarter that should increase in the June quarter, but I wouldn't say substantially. And then it all comes down to really how the seasonality affect it and do we need to start producing earlier in the June quarter to be able to meet the really massive expected ramp in the second half of the year.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [4]

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So just -- if I could follow up on that. So there sounds like there's 2 variables into the back half. One, when do you fill inventory in anticipation of the back-half ramp, and two, is the back-half ramp suppliable? I.e., can you deliver enough volume industry wide to make the forecasts in the back? Should -- it sounds like it should be tight even as you're adding capacity. Is that the right way to think about it? And then, the only other piece is, can you give us some sense of where do you stand on pricing? That's the other variable that people don't have a handle on.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [5]

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Yes. I think, as we demonstrated in the end of 2017, we can add capacity very rapidly and ramp to volumes that are pretty steep. And that's really enabled by both our manufacturing process as well as our design to hit high yields. So I'd say, whether we build inventory in the June quarter for the second half of the year, it's still being worked out. I do expect that we will start higher levels of production in the second calendar quarter to be able to meet the needs and demand in the third calendar quarter and fourth calendar quarter. As far as your question on pricing, we stay away from that. I will say, though, that I think that through continued improvements in yields and cost reduction of our supply chain, we expect that the gross margins will still be very healthy as we go forward into fiscal 2019.

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Operator [6]

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Our next question comes from Joseph Wolf from Barclays.

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Joseph Eric Wolf, Barclays Bank PLC, Research Division - MD & Head of Equity Research [7]

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I guess as a follow-on to that prior question. If you think about the trajectories and what you're thinking about as you add capacity for the edge, what kind of mix do you think you're going to have customer-wise if we look out 18 months?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [8]

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That's a good question. I would say it's very dependent upon the number of models that the Android customers put 3D sensing on. And they're very, very secretive with regards to that. So it's hard to say. I will say, though, that I would expect 18 months from now that we'll have substantial edge-emitting revenues. Even 12 months from now, substantial edge-emitting revenues. So it'll certainly be much more balanced as we bring on multiple customers. Some of which will use VCSELs and the others will be using edge-emitters.

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Joseph Eric Wolf, Barclays Bank PLC, Research Division - MD & Head of Equity Research [9]

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Will the margin profile for the company be the same based on the strategy of manufacturing in-house versus outsourcing as the edge comes online?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [10]

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I think it won't be dramatically different. I think that the manufacturing structure and partnerships we have on VCSELs today is extremely efficient, and I would put our supply chain up against any vertically integrated supplier today. The edge-emitters, I think is unique in that the process and technology that we have for edge-emitters allows us to hit high volumes at, I think, pretty aggressive cost. So I think that the margin profile will be similar.

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Operator [11]

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Our next question comes from Patrick Newton from Stifel.

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Patrick Michael Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Senior Analyst [12]

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Alan, Aaron and Chris, congratulations on the solid quarter. I guess on 3D sensing. If we look at the 3D sensing supplier landscape, you have a competitor that's vertically integrating sensor at market in 2019, another has an aggressive ramp that looks unlikely to be able to achieve production they need to carve out the largest customers' design cycle the back half of this year, and you have a final one that's only supplying the flood arrays. So you're in a very enviable position. I'm curious if you've been able to turn this position into a longer-term supply agreement with your key customer. And given the ramp you see in the second half of the year, you did talk to expanding capacity with long lead times. Would you expand capacity without some form of guaranteed share or units?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [13]

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Yes. Thanks, Patrick. I hesitate to comment on our negotiations or contracts with any customer, but I would say that our confidence is high enough that we are spending time, resources and capital on expanding our production capability, both on our edge-emitters as well as on our VCSELs and with our partners that we use in our supply chain. So I think our confidence is high that the demand will be substantially higher than it was in 2017. And that we should maintain a very high level share of that business.

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Patrick Michael Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Senior Analyst [14]

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Great. And then as my follow-up, I believe you said that non-3D sensing revenue is actually going to increase by $25 million to $35 million sequentially. So I'm calculating that your implicit March 3D sensing guide is about $60 million. Is that accurate? And if so, if we balance Android and EMLs and the potential for a build in June ahead of the back half, could June trends actually be flat or maybe even up? And then on the flip side of that, that sequential uptick in the non-3D sensing business is pretty impressive given seasonality. So you spoke to lasers being higher, but can you walk through some of the optical drivers?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [15]

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Yes. So Patrick, thank you. In terms of the drivers for the non-3D sensing being up, Telecom pumps, ROADMs are very, very strong. Our industrial lasers, commercial lasers for both micromachining and kilowatt lasers, we have more demand that we can supply at this point in time. Both kind of picked up. Our commercial lasers will exceed $50 million. And that's been a target we've been pursuing for a long, long time. Healthy margins as well. In terms of your calculation at a high level for 3D sensing, what we can say is our 3D sensing will be materially down or significantly down here in the quarter, probably 60 -- 60 to 5 -- 5% or so down. So in terms of the exact number, we're not going to comment on the exact number, but from the seasonality standpoint, yes. The March quarter and June quarter are seasonally lower periods. However, as Alan had mentioned in his prepared remarks and in some of the Q&A already, we look at the June quarter with ramps heading into the back half of calendar '18. We're adding capacity and so we're not going to -- we only guide one quarter at a time, but we feel pretty confident on where this business is going balance of calendar '18.

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Operator [16]

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Our next question comes from James Kisner from Loop Capital Markets.

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James Martin Kisner, Loop Capital Markets LLC, Research Division - SVP [17]

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So I appreciate your comments on ROADMs. I was wondering if you're able -- give us a little more detail. Maybe talk about where the revenue kind of is now. I mean, you kind of peaked around $60 million a quarter. Are we there yet? And -- or in this last quarter, we hit that kind of high-water mark and you're close to it? And just wondering the longer-term outlook, I mean, could ROADMs hit a kind of annual high here in calendar 2018?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [18]

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Yes. Thanks, James. So in terms of ROADMs, we're not going to give out the specific number, primarily because we're not doing that for any of these different products. But yes, ROADMs bounced back. It was strong. We were up 22% or so. We saw strength in both North America as well as in China. China was about 20% of the total ROADM volume. So a healthy rebound there as well. And as we have been mentioning in previous calls, the ROADM deployment in China, we believe is going to occur here in the back half of calendar '18 and through calendar '19 as they go and build out a lot of the networks and -- in a lot of the large cities going forward. And in terms of North America, we're beyond a lot of the inventory rebalancing that has occurred the last couple of quarters, and we're seeing strong demand from our customers who deploy into the folks in North America.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [19]

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Yes. I think maybe just to add to that, we are adding capacity for ROADMs today, so I would expect, to your point, our ability to get a new peak level of ROADM revenue this year is very highly likely.

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James Martin Kisner, Loop Capital Markets LLC, Research Division - SVP [20]

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Great. And then just one follow-up. On Datacom, the issue there is becoming pretty well known on CWDM4. I'm just wondering if you could comment on your participation just to monitor trajectory of that business in calendar ‘18.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [21]

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Yes. I think the CWDM4 business is a highly priced competitive. As I said in earlier earnings calls, we have a very focused effort in our development team to introduce an extremely low-cost version of that product to be able to compete at the hyperscale level. And today, we don't have that to make it make sense to have a big volume at the hyperscale guide. But later this summer, we'll have a product that we think we can have decent margins or good margins selling at the hyperscale level at the prices they expect. So I'd say that it's challenging today, but we have a plan to invest it in the coming quarters.

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Operator [22]

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Our next question comes from Tim Savageaux from Northland Capital Markets.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [23]

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Congrats on the strong quarter and the cash generation. I guess I'm looking to dig a little bit deeper into the semantics of really massive, I guess. And I did a little work on that, actually, earlier this week and making some assumptions around unit volumes, concluded that the total dollar value of the opportunity with -- just with your largest customer, could more than double, substantially more than double year-over-year, say, from the second half of '18 versus '17. So we're hearing suppliers -- I think you referenced maybe up and down the food chain, industry leaders talking about these types of ramps in the second half. You mentioned a couple of times an increase in production starts heading into Q4, although I'd be curious as to increase relative to what? Perhaps, an increase relative to what you just reported here in the December quarter. So I've thrown out a few metrics there. You can take your pick, but I'm trying to get a better sense of the type of year-over-year growth dynamic that you might be looking for kind of second half '18 versus what you've just reported second half '17 and whether that kind of your doubling tight metric is reasonable.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [24]

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Yes. I think if you just look at units, models that should have 3D sensing capabilities in it, you're spot on and that unit volume should more than double. And then you layer on top that the market for Android and the timing of when they'll be introducing 3D sensing into their product lines, I think you could have more than double the -- of that potential market in the second half compared to what the second half of fiscal -- or rather, calendar '17. So I think your numbers are aligned with our expectations about market growth.

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Operator [25]

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Our next question comes from Troy Jensen from Piper Jaffray.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [26]

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So on the ROADMs being up sequentially in March, just to be clear, you expect both the U.S. and China growth?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [27]

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Yes.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [28]

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In the U.S., can you say whether or not Verizon seems to be accelerating orders?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [29]

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With staying away from specific customers, I'd say that North America metro is seeing a pickup in deployments and demand expectations for us in both the March quarter as well as the June quarter.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [30]

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Okay. Perfect. And then maybe one for Aaron here. I'm not an accounting expert, by any means, but guess I thought when you take the deferred tax asset out of the balance sheet, you need to start reporting a full tax rate. And I understand you won't be -- on the cash flow statement, you'll still be absorbing the NOLs. But should we be modeling a higher tax rate here in future quarters?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [31]

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At this point in time, Troy, I think our tax rate is going to be similar to what we've seen in the past, so somewhere between 6% and 10% depending upon the geography of where the income is generated. But when we separated from JDSU, we had a tax-optimized structure. And so I think we're still in good shape. We're going to be evaluating the new tax legislation over the next few months. And there could be some pluses and minuses here or there, but I don't think there's going to be anything material at this point in time.

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Operator [32]

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Our next question comes from Simon Leopold from Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [33]

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I want to make sure I'm really understanding your commentary of non-3D sensing business being up $25 million to $35 million. You were kind enough to indicate lasers would be over $50 million, so that gives us some boundary around where the rest of it comes from. It sounds like strength from ROADMs and pumps would need to be in the neighborhood of $20 million sequential growth to get to that March suggestion. I just want to make sure I'm interpreting all of this correctly, given that March is typically a tough seasonal quarter on price resets. Did I get the math right here?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [34]

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Yes. That's correct, Simon. In terms of the commercial lasers product lines, both micromachining and kilowatt lasers, we have more demand than we can satisfy. And so we're going to be growing in the $50 million range. In terms of the Telecom product line, very strong demand for Telecom pumps. We can't produce enough in some cases. And then in terms of ROADMs as well for both North America and China, we have demand picking up. And so as Alan had mentioned, we're going to be adding capacity as we look forward here through calendar '18.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [35]

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Okay. And in terms of where the 3D sensing business is going. I appreciate you don't want to give us full June guidance, but just to give us order magnitude of what kind of patterns to expect given sort of product cycles, new customer wins. Is it reasonable to think of June as sort of the bottom for 3D sensing, given sort of normal patterns of orders that it could be roughly half of the March sales and then ramp after that? Is that the right way to think about June in 3D?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [36]

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I would say that we don't guide more than a quarter at a time, but I'd say that the first half of the calendar year is the trough. And how that spreads between the March quarter and June quarter is still to be determined. So I think we're expecting and preparing for a very rapid growth in the second half. And that means ramping up production again with wafer starts in the April, May time frame. So I think second half is what we're focused on, and whatever happens in the March and June quarter is what's going to happen.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [37]

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And then a longer-term question. There's been a lot of press around the Chinese government trying to reduce the nation's dependence on imported optical components. And they've named a number of categories, which includes 3D as well as ROADMs as areas where they'd like to develop domestic supply. We've generally thought about this -- all of these technologies as pretty hard to do. And so it's not an easy barrier. But wanted to get your perspective of how this may differ from your past expectations, how you gauge the threat and what sort of trend you expect in terms of China reducing its dependence on imported products such as yours?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP of Strategy & Corporate Development and Interim CFO [38]

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Hey, Simon. This is Chris. I think in the products that you've highlighted, 3D sensing and ROADMs, while there may be some objectives of having domestic supply in China, these are products that are quite challenging to make a lot of intellectual property where, in the case of ROADMs, over the years, have seen fewer competitors, not more competitors emerging. We think that's a space where there's probably going to be limited developments in China domestically. We think the -- where we'll continue to see China supply develop around is probably around transmission products, whether that be Datacom or Telecom at the module level. And so that's why we're heavily focused on ensuring that we have world-class and world-leading component capability to be able to either compete at the module level or in areas where we're challenged due to government support in China, to be able to provide at the component level and still get our fair share of the big spend in China.

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Operator [39]

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Our next question comes from Doug Clark from Goldman Sachs.

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Douglas G. Clark, Goldman Sachs Group Inc., Research Division - Equity Analyst [40]

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Just one quick question on 3D sensing. Can you give us an update on what your expected timing for the auto adoption is?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [41]

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Oh, it's longer term. I'd say that it's not meaningful revenue probably until 2020 calendar year because there's none.

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Douglas G. Clark, Goldman Sachs Group Inc., Research Division - Equity Analyst [42]

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Okay. Okay. And then a question or a clarification on some comments that you made on China kind of ramping ROADM deployments throughout the year. Is this also an indication of your broader expectations just for China procurement across kind of modules and transceivers for the Telecom business? Or is this a more ROADM-specific comment and expectation?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [43]

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Yes. Our comment on ROADMs was really more the look at deployments of ROADMs as incremental opportunity for us. And we believe we're capturing a very large share of the high-end ROADM deployments in China. I'd say that China, overall, has reduced inventory levels. So we're encouraged by that in the non-ROADMs space. But they're -- we're struggling to satisfy the ROADM demand that we have today for China. So I think longer term, as major deployments happen -- I mean, we're adding capacity to be able to address that. And that's why I said earlier that we believe this year, we could achieve a new record level of ROADM revenue.

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Douglas G. Clark, Goldman Sachs Group Inc., Research Division - Equity Analyst [44]

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Okay. That makes sense and that helps. Final question. Just with an influx of cash and just a more cash-generative business, can you give us an updated view on M&A? Or potential kind of product adjacencies? Or supply -- capacity adjacencies that might be interesting?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [45]

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Yes. So in terms of M&A and cash generation, Doug. So we continuously evaluate our capital allocation strategies and our uses of cash. And in terms of strategic alternatives, the industry, probably, will consolidate at some point in time. The industry structure needs some change. But in terms of being able to discuss anything at this time, we're not prepared to talk about anything specifically. But in terms of the cash generation, we are pleased with what we've achieved here in the quarter. And it highlights the operating model and the strength of what we're able to produce here as volume increases.

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Operator [46]

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Our next question comes from George Notter from Jefferies.

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George Charles Notter, Jefferies LLC, Research Division - MD & Equity Research Analyst [47]

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I guess I wanted to ask about 3D sensing orders and aggregate. I think last quarter, you guys talked about having received $300 million in orders and aggregates since the 3D sensing opportunity really emerged. Can you update that number now, just out of curiosity? And then separately, I guess I had a question about the upside in the quarter on 3D sensing. Any more you can provide in terms of -- was that driven by yield improvements? Was it driven by just raw increases in capacity? And then any gating factors as we look forward as you think about capacity on 3D sensing?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [48]

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Yes. We gave specifics on the backlog previously just to let you know that our guidance was founded on orders we had in house. We're not going to do that anymore. We don't give booking updates on any product lines, so we're not going to do that. I will say that during the quarter, we did receive significant orders. So that's why we believe that we're in good shape for the first half of the calendar year. And as far as upside in the December quarter, I think it was really a matter of strong demand and our ability to ramp at high yields on the 2 products that we have in volume. So we're very pleased with the progress that the team has performed and expect us to continue to perform at even higher yields and lower costs to be able to maintain those nice margins.

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Operator [49]

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Our next question comes from Thejes Venkatesh from UBS.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [50]

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3D sensing question from me as well. We know you're at 40 -- above $40 million of 3D sensing revenue in the October month. And then generated $216 million for the whole quarter. So based on that, it looks like you have $1 billion of annual 3D sensing VCSEL capacity already, implying you can handle doubling demand next year potentially. And you're still talking about adding additional capacity. So can you sort of help reconcile that?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [51]

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Yes. So just one clarity. The $216 million was our consumer -- with our industrial diode laser business included with our 3D sensing. So total 3D sensing was just over $200 million. So you're right. We did $160 million in the November-December time period. I'd say that we're adding capacity because we think it's going to be even bigger. But it's also seasonal, so you can't just expect to build $80 million a quarter to get to -- $80 million a month to get to $1 billion market. I'd the other thing is that we are introducing edge-emitting lasers, which uses a different supply chain and different technology. So we have to add capacity for both VCSEL to be able to hit the peak demand as well as for edge-emitters that we're starting to ramp in the 2019 time frame that we'll see first real revenue this quarter.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [52]

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Got it. And just a follow-up. Looks like the profitability of this business is better than previously thought. Can you talk a bit about how you're thinking about competition in fiscal '19? And if there's potential to continue improving yields?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [53]

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Yes. I mean -- I think we're always fearful of competition. That's the nature of the business we're in. And the only way we can compete effectively is to continue to drive costs down. We believe that our supply chain is super-efficient, and we'll -- I'll put it head-to-head with any vertically integrated supply chain. And so I think from that perspective, even with price reductions, we expect that the margin profile of 3D sensing across our product line -- across our customer base is going to be lighter as we go into 2019.

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Operator [54]

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Our next question comes from Mark Kelleher from D. A. Davidson.

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Mark Daniel Kelleher, D.A. Davidson & Co., Research Division - VP & Senior Research Analyst [55]

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I just want to look at the gross margins a little bit. Very strong sequential uptick. And you mentioned that that's in mix. And I'm kind of curious as to how we should look at the range of gross margin going forward given the seasonality of your VCSEL sales? Is there a cycle that goes through? Are there -- or is the ROADM sales and the pump lasers? Is that pulling it up as well? Can you just tell us some puts and takes on what we should look for in gross margin?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [56]

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So in terms of the margin in commercial lasers, product lines. So we were 44.7% in Q2 or so. And we believe we're going to be in that range, and our longer-term model has us going towards 50% over time. More of the volume was weighted towards Optical Communications, primarily because of the big quarter we had with 3D sensing. We had indicated in the past that our 3D sensing gross margins would be over our corporate average, and they were significantly over our corporate average -- our historical corporate average. In terms of going forward, so it's going to be a function of the mix of 3D sensing against our total volume as well as the mixture of commercial lasers as well. Our Telecom pumps and ROADM product lines have good gross margins as well, which should help us as we go forward.

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Mark Daniel Kelleher, D.A. Davidson & Co., Research Division - VP & Senior Research Analyst [57]

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So the 10 points increase sequentially, can you break that out as to what contribution came from 3D lasers?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [58]

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Yes. So we're not going to split that out specifically. But it was a function of the mix from 3D sensing as well as the large volume uptick. 66% increase in top line contributed a lot to that as well.

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [59]

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And 14% improvement in commercial lasers.

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Operator [60]

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Our next question comes from Meta Marshall from Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [61]

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A couple of quick questions. On the Datacom market, are there any kind of 400G product introduction that we should think of kind of towards the latter half of 2018 or into 2019? And then second, on ROADMs in China. Is that still primarily China Telecom demand? Or have you seen any movement on China Mobile to incorporate ROADMs in 2018 versus 2019?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [62]

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Sure. Datacom 400G, you won't see revenue really this year. It's really more of a back half of calendar '19. As far as ROADMs, China Telecom, as you say, is clearly leading the way. And we expect that the other carriers in China should start deploying late this year -- late this calendar year or early calendar '19. But the majority of the deployments to date have been China Telecom as well as the ROADMs that we ship into China that end up in EMEA or other regions as well.

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Operator [63]

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And our last question comes from Richard Shannon from Craig-Hallum.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [64]

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Maybe I'll ask a couple of questions primarily related to 3D sensing. I wonder if you can give us your sense as you see it right now of kind of the go-forward opportunity 2, 4, 8 quarters out, both for the Android ecosystem versus your -- kind of your current customer base? And also get a sense of scale of what you think the edge-emitters can do versus your initial early stage or your initial with -- ramp ups with VCSELs?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [65]

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Yes. Well, so I think the edge-emitters certainly have their set of strengths. And customers come to us because they can try both different technologies and choose whichever one they want. And we're -- we don't care which one they choose. We have the technology to supply both. So I'd say that customers have chosen their path. And many of them have chosen edge-emitters, which puts us really in a very, very solid position. I'd say, for your first question about the go-forward 2, 4, 8 quarters out, my expectations are that we add significant numbers of customers that are Tier 1 smartphone device manufacturers in the 4- to 8- quarter range for sure. And a question in my mind is really that, do we see meaningful Android customers in the second half of calendar '18? And I think the answer is probably yes. But it's really up to us to execute and them to execute as well. So I think from our perspective, we're adding the capacity in anticipation of that happening. But I think that calendar 2019 is going to be a solid year with less seasonality like what we're seeing here today given the introduction timing of the different smartphone manufacturers. Did I answer your...

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [66]

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Okay. That's helpful. Yes, yes, it did. I know you can't size these quantitatively. I think that's a good starting point. I'm sure we'll continue to ask questions on that topic. My follow-up question related to gross margins. Obviously, you mentioned 3D sensing gross margins are above corporate average. And while you haven't quantified what they are, how do you view the gross margins in 3D sensing as you kind of ramp up in 2 to 4 quarters from now? Can they be at the same level they've been at the last couple of quarters? Or will it be higher or lower?

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Aaron L. Tachibana, Lumentum Holdings Inc. - Former CFO & Executive VP [67]

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Yes. Thanks, Richard. In terms of gross margins, as we go forward, it's our belief and expectation that gross margins will be similar to where we're at today primarily because, as Alan had highlighted, we have continuous cost reduction initiatives, yield improvement aspects, throughput. And we'll continue to optimize our supply chain, which will give us lower costs over time irregardless of what happens with selling prices.

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Operator [68]

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And there are no further questions at this time. I'll now turn the call back over to Alan Lowe, President and Chief Executive Officer, for closing remarks.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [69]

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Thank you, Kelly. I want to thank our customers for their business and partnership. I also want to thank our employees for all their hard work in helping us achieve new record revenue and earnings results and putting us into an excellent position for long-term growth. We regularly discuss our business at Investor Relations events. These events are listed on our website in the Investor Relations section and regularly updated.

This concludes our call for today. We would like to thank everyone for attending, and we look forward to talking with you again in another 3 months.

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Operator [70]

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This concludes today's conference call. You may now disconnect.